Japan’s Economic Experiment

By Peter Drysdale
East Asia Forum

The Bank of Japan sent a new shock-wave through financial markets last week when Governor Haruhiko Kuroda announced another massive round of monetary expansion (Quantitative Easing or QE). The additional boost to the Japanese money supply was accompanied by a sharp lift of 4 per cent in the Nikkei stock market index and the yen falling to a seven-year low against the dollar. Some now fear that the impact of Japan’s monetary expansion will lead to the outbreak of a serious currency war. Since 2012 the yen has fallen 50 per cent against the Chinese yuan and 40 per cent against the US dollar, the euro and the Korean won.

Bank of Japan (BOJ) Governor Kuroda. Photo courtesy AAP.

Kuroda, who has been widely praised for his leadership of the Bank of Japan (BOJ) into unchartered waters, where ‘conventional’ monetary policies provide no sure compass, is now facing the heat, in the Diet, in the press, and among business circles worried about the rising cost of imports. The entire Abenomics strategy is under more and more intense scrutiny.

Under Kuroda, in March–April 2013 the BOJ did a 180-degree turnaround: declaring that it had the clout to end Japan’s chronic, if mild, deflation and secure a rate of inflation of around 2 per cent and announced bold monetary action to that end. This was revolutionary stuff — and it was coming from establishment Japan. Kuroda’s predecessor, Masaaki Shirakawa and his team, had resolutely insisted that the bank could not break deflation using monetary policy alone, the root cause of which in Japan was the steady decline in real potential growth, which was driven largely by demographic factors and therefore not directly amenable to monetary policy cure.

There is much intellectual weight behind the BOJ’s new course: a central bank, with the monetary instrument at its command, may not be able greatly to affect real economic variables like potential output growth, but standard economic analysis is pretty clear about the ability of monetary policy to affect a monetary or nominal phenomenon, like the inflation rate or the path the aggregate price level takes. A central idea in modern monetary theory and practice is that central banks both need, and are able, to ‘anchor’ the public’s inflation expectations around its inflation target: central banks control inflation to a significant extent by convincing the public that they can and will meet their inflation target. ‘If the starting point is one of deflation, supported by the public expecting deflation to continue in the future’, as Paul Sheard puts it, ‘and the central bank itself tells the public that it does not believe it has the tools to end deflation, then that just serves to entrench deflation even further’. And that’s just what the BOJ, pre-Kuroda, appeared to be doing.

The first arm of Abenomics was thus a complete turnaround on the monetary policy stance, quickly and boldly executed. The second arm — fiscal expansion and the promise of fiscal consolidation — followed soon enough after. The third — structural reform and productivity-boosting investment — is yet to come. And more than a year out, the problem for Kuroda is that the BOJ’s inflation target now looks distinctly limp: just half way there on the latest data, having fallen back from a peak of 1.5 per cent.

So how much of a push on the monetary lever is enough? And how much is too dangerous? It appears that four of the nine on the BOJ board wouldn’t go along with the latest push. Recently Sheard presciently argued that the ‘deflation-expunging tipping point may require surprisingly aggressive policy, far beyond what the BOJ is currently doing, and Mr. Kuroda may be hamstrung by other policy board members, some of whom disagree with his assumptions and framework’.

If so, and the BOJ comes up short, there are implications for other countries (in Europe in particular) not only Japan. If the BOJ’s ‘can do’ approach succeeds, it will create a positive precedent for central bankers elsewhere struggling to deal with deflation and economic stagnation.

In this week’s lead, Hugh Patrick lauds the success of Abenomics in restoring Japanese confidence but notes that the initial exuberant optimism has waned. Yet, those who say it is a failure are judging prematurely, he cautions.

‘Abenomics is not a quick fix; implementation will take years. Monetary policy has successfully halted deflation, but achieving and then sustaining an annual 2 per cent increase in consumer prices will be a major challenge. Fiscal policy’s major challenge persists: achieving sufficient private consumption and investment demand growth so that fiscal consolidation can be implemented. Structural reform to achieve growth requires a wide range of policies, so it is a thousand darts, not a single arrow’.

The immediate challenge is how rapidly and how well the economy can rebound from the consumption tax increase in April. Recent forecasts were hoping for 4.1 per cent growth over the summer quarter, but the most recent data suggest the rebound is disappointing.

This is a very risky time for the whole Japan economic experiment. In the coming months, the Abe government faces some major decisions. The most important might be, as Patrick says, whether to pursue the 2 percentage point consumption tax increase scheduled for October 2015. If third quarter GDP growth results, to be announced on 17 November, are disappointing, then Abe may cut and run. Whatever one’s view about the timing of the consumption tax hike, to abandon the strategy now would add to the growing corrosion of confidence in the whole Abenomics package. Symbolically, the Trans-Pacific Partnership (TPP) free trade agreement negotiations are still hanging in the balance, and some would argue that the new US Congress makes that a deal now more difficult to do to Japan’s political if not economic liking. All the action in Abenomics has to be in the third arrow of structural reform of which the TPP is a small but emblematic part. Structural reform will make or break the strategy and the longer term health of the Japanese economy. And there are no quick or single fixes yet in sight.

Another question is the link between Mr. Abe’s economics and his rather strident nationalist politics, which play negatively into the Northeast Asian region in which the external dimension Abe’s economic reforms will ultimately succeed or fail. The inconsistencies in Abe’s diplomacy, as Patrick suggests, undermine building the floorstones for economic confidence. In China this week, an APEC side-summit between President Xi of China Prime Minister Abe could just see the first steps in breaking through these problems between China and Japan, as we foreshadowed here last week, and the gradual development of an external political environment that is congenial and necessary to achieving what Japan is trying to achieve economically.

Courtesy of East Asia Forum

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